Chapter 4
Margin lending, promissory notes and trustee corporations
Introduction
4.1
At their 26 March 2008 meeting, where the Council of Australian
Governments (COAG) agreed to nationalise consumer credit regulation, COAG also
reached in-principle agreement that the Commonwealth would assume regulatory
responsibility for margin lending and trustee corporations.[1]
4.2
The Corporations Legislation Amendment (Financial Services
Modernisation) Bill 2009 contains the government's proposed measures to introduce
responsible lending obligations for margin lending, establish a more consistent
approach to the regulation of promissory notes and debentures and require
trustee companies to hold Australian Financial Services Licences.
Corporations Legislation Amendment (Financial Services Modernisation) Bill
2009
4.3
On 3 June 2008, the Government released a green paper which canvassed
'seven critical areas of Australia's financial services'[2]
including trustee corporations, margin loans and promissory notes. The green
paper received 76 submissions. On 7 May 2009, after further consultation
with a panel of industry and consumer groups, an exposure draft of the
Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009,
plus draft regulations relating to margin lending, was released for public
comment.
Interaction with the National
Consumer Credit Protection Reform Package
4.4
Many of the issues addressed in the green paper are the subject of either
the National Consumer Credit Protection (NCCP) reforms or this bill.
4.5
Significantly, the responsible lending obligations, which are an
important part of the NCCP bill, will also be introduced into the Corporations
Act and applied to providers of margin lending products, creating substantial
cross-over between the two bills. Additionally, margin lending providers will
be subject to new dispute resolution requirements, including a requirement that
they be members of a registered External Dispute Resolution (EDR) scheme.
4.6
However, there are also some important differences between the
regulation of marking lending, trustee companies and promissory notes and the
regulation of consumer credit. These differences are explained in more detail later
in this chapter.
Committee view
4.7
The Committee acknowledges that the responsible lending obligations
which will apply to margin lending products as a result of this bill
substantially reflect the obligations under the NCCP bills and that margin
lending providers will have similar dispute resolution requirements. However,
the Committee believes that there are other issues that must be considered in
discussing the regulation of margin lending products because of their unique
position as both a credit product and an investment product.
Margin Lending
4.8
The ASIC website 'Fido' defines a margin loan as follows:
A margin loan lets you borrow money to invest in shares and
other financial products, using existing investments as security. Borrowing
money to invest in this way, also known as ‘gearing’, can increase the gains
from an investment, but also multiply the losses. Margin loans are offered by a
wide range of financial institutions and are often available online.[3]
4.9
Margin lending typically involves the investor borrowing funds (sometimes
up to 80 per cent of the total value of a portfolio of listed shares, fixed
interest securities and/or units in managed funds) to supplement an initial
investment. Investors hope that the value of the overall portfolio will grow, increasing
the equity in the portfolio. Investing using margin loans can also have
taxation benefits.
4.10
However, as indicated in the ASIC definition, the risks involved with
investing using funds from a margin loan can greatly exacerbate the risks
associated with normal investments.
4.11
Typically, a lender will approve a margin loan for a consumer whereby
the value of the loan amount cannot exceed a certain percentage of the loan's
security. This is called the Loan to Value Ratio (LVR). When the value of the
overall portfolio falls so that the LVR rises to greater than the level
originally approved by the margin loan provider, the lender issues a 'margin
call'. This requires the investor to return the ratio to below the approved
level by giving the lender additional security, reducing the size of the portfolio
(by selling some of the assets) or paying extra cash.
4.12
The money that investors borrow in a margin loan is generally backed by
the securities or financial products owned by the investor (such as listed
shares). In recent years, however, some lenders have encouraged investors to
provide other assets, such as their home or investment properties as
collateral.
4.13
In instances where a margin lender issues a margin call and the borrower
is unable to bring the LVR down below the approved level, the borrower may be
exposed to the lender calling in the margin loan.
Margin Lending in Australia
4.14
In his second reading speech on 25 June 2009, The Hon. Chris Bowen MP
said,
Over the past 12 months, in the fall-out from several
high-profile financial collapses, many investors lost hundreds of thousands of
dollars due to margin loans. And in some cases, they even lost their family
homes. While properly-geared margin lending, backed by full disclosure, does
have a place in our financial services landscape, we cannot tolerate ordinary
Australians being misled into grossly inappropriate margin loans that can cost
a family everything they own.[4]
4.15
Chart 1 shows the substantial increase in how much investors have
borrowed in margin loans since 1999. It also shows the ‘aggregate credit
limit’, which is the sum of the lenders’ approved loan limits, or the total
amount lenders are willing to lend under margin loans. The value of the
underlying security (the shares) is also depicted. The chart shows that,
between December 2000 and December 2007, the proportion of total lending to the
aggregate credit limit remained similar as the market for margin loans grew.
Between December 2007 and December 2008, as the value of many stock market
products fell, the total value of the securities used to back margin loans
dropped below the aggregate credit limit, but not below the total borrowed. This
chart shows aggregate figures. For some individual consumers, the value of the
underlying securities may well have dropped close to the amount borrowed. In
such instances, it is likely that a margin call would be issued (see Chart 2).
Source:
Secretariat prepared from RBA Data – Margin Lending D10 – June 2009
4.16
According to the Reserve Bank, there were 199,000 margin loan client
accounts in Australia in June 2009 (from a high of 206,120 in June 2008).[5]
The tendency for significant downturns in the stock market to be correlated
with higher numbers of margin calls is illustrated by Chart 2.
4.17
Considering the significant increase in the use of margin loans in times
of economic growth and the potential for 'mum-and-dad' investors to be
adversely affected by a downturn in the stock market, the lack of regulation of
these products is of great concern.
Chart 2: Margin
Lending In Australia
Source: Reserve
Bank of Australia – Statement on Monetary Policy August 2009
The proposed reforms
4.18
Margin lending has not been subject to any specific regulatory regime,
at either the State or Commonwealth level. Treasury state:
Margin lending facilities are not regulated as a financial
product, or subject to Australian Securities and Investment Commission (ASIC)
supervision relating to financial services. This is because the term 'financial
product' in the relevant legislation does not cover credit products (such as
margin loans) as a result of the current referral agreement with the States and
Territories. Further, State and Territory legislation governing consumer credit
(the Uniform Consumer Credit Code) excludes investment loans such as margin
lending.[6]
4.19
Margin loans are a contractual arrangement between the lender and the
client. Primary disclosure of the terms and conditions governing the loan
occurs through the lending agreement signed between the two parties. As this
disclosure is not currently regulated it is not clear that investors are fully
aware of the risks associated with a margin lending product.
4.20
To address inconsistencies in the regulation of margin loans, the
proposed legislation includes margin loans as financial products for the
purposes of Chapter 7 of the Corporations Act 2001 (which regulates the
provision of financial services supplied in relation to financial products,
particularly for investment purposes). This will establish an investor
protection regime by ensuring that margin loan providers will be subject to the
licensing, conduct and disclosure requirements in Chapter 7 as well as supervision
and enforcement action by ASIC.
4.21
The margin loan regulatory regime will only apply to margin loans taken
out by natural persons, including persons acting as a trustee of a trust. This
means that margin loans taken out by companies, including small businesses and
family companies, will not be subject to this legislation. Treasury explain
that this approach avoids any potentially inappropriate outcomes for large
corporate borrowers.[7]
Evidence in relation to Margin
Lending
4.22
The main issues raised in relation to margin lending were the inclusion
of margin loans as a financial product in the Corporations Act, rather
than in the consumer credit legislation, the introduction of responsible
lending obligations for margin lenders and the treatment of margin call
notifications within the bill.
Margin Lending's inclusion in the
Corporations Act
4.23
Treasury explain that the main reason for including margin lending in
the Corporations Act is:
...that it provides key protections to borrowers such as access
to free dispute resolution arrangements, disclosure of important information
and assurance that margin loan providers and other service providers are
appropriately resourced and competent.[8]
4.24
The Securities and Derivatives Industry Association (SDIA) highlighted
their concern about the impact on their members of the inclusion of margin
loans as a financial product:
Whilst understanding why the government has taken these
measures in regard to margin lending, SDIA has always struggled with the categorisation
of the funding facility for the purposes of financial products as a financial
product itself. Our members are now faced with new measures for disclosure and
unsuitability tests which differ from other financial products.[9]
4.25
MinterEllison have argued that the proposed framework creates a significant
discrepancy between how different investment products will be treated.
The Government proposes to address other investment loans in
phase two of its credit reform program. We understand that these will include
loans secured by residential property mortgages to acquire investment products
and securities. As these loans will relate to investment products and
securities, the regulation of margin lending under the Modernisation Bill would
suggest that they should be regulated under the Corporations Act. On the other
hand, given they are secured by residential property, the Credit Bill would
suggest that they should be regulated under that legislation. Neither result is
entirely satisfactory.[10]
Licensing
4.26
The bill requires margin lenders to hold an Australian Financial
Services Licence (AFSL). The Securities and Derivatives Industry Association
have indicated that all their members currently hold an AFSL.[11]
However, they also mention that:
...amendments and variations to all licences will be necessary
for those issuing or advising in margin lending, which will be most of our
Members, and hundreds if not thousands of licensees across the industry. ASIC
implemented an effective streamlining process in the lead up to re-licensing
under FSR. We urge ASIC to streamline the necessary arrangements to facilitate
the licence variation process during transition.[12]
4.27
In the June 2008 green paper, Treasury explain that one advantage of
including margin lending in the Corporations Act 2001 is the strength of
the licensing regime and its administration by ASIC. They argue that any
separate licensing regime for margin lenders would unnecessarily mirror those
provisions and create regulatory overlap for businesses offering margin loans and
other financial products.[13]
4.28
Treasury go on to say that inclusion of margin lending in Chapter 7 of
the Corporations Act is considered to be the option which imposes the least
regulatory burden on industry with respect to licensing.
Most margin lenders and financial planners are already in
possession of an Australian Financial Services License (AFSL) issued under
requirements specified in Chapter 7. Obtaining authorisation to issue or advise
on margin loans will require a variation to an AFSL [however] this is a simpler
process than requiring lenders and advisers to obtain a separate credit
licence...[14]
4.29
MinterEllison have lodged an argument that a separate licensing regime
should be established but concede that:
...if the Government continues to insist that the credit
licensing regime should be based upon the FSR licensing regime then credit
licensing should be included within Chapter 7 of the Corporations Act.[15]
The Responsible Lending Obligations
4.30
As mentioned above, the new regulatory regime for margin lending also
includes responsible lending obligations for margin loan providers.
The main purpose is to require lenders before providing
credit to make an assessment whether the product is unsuitable for the
consumer. If the assessment considers that it is [unsuitable], then the loan
may not be provided...
While the majority of margin loans are not causing any
problems for borrowers, there is evidence that in some cases borrowers have
been given margin loans with features and risks that they did not fully understand.[16]
4.31
The bill includes a requirement that margin lenders do not provide a
margin loan if the loan is unsuitable or the borrower cannot service the debt (or
if servicing the debt would cause substantial hardship). The factors that
lenders must consider are contained in the regulations.
4.32
The Securities and Derivatives Industry Association commented on whether
financial advisors are in a position to make such an assessment.
The adviser will have to address the matters set out in
regulations as to whether the debt would be serviceable by the client. It would
be more of a credit check like banks do: the source of funding for the equity
that the client is putting in to make sure that that equity is not already
encumbered and checking whether there are existing mortgages or other financing
arrangements on that equity to secure the loan. These are checks that advisers
do not normally make.[17]
4.33
The Financial Planning Association of Australia were less concerned
about the ability of planners to assess the financial capacity of their
clients. They were, however, concerned that the responsible lending obligations
only apply where the financial planner was genuinely providing credit
assistance. They highlighted their concern about financial planners who provide
'incidental' credit advice.
Financial planners assist their clients with strategies to
identify and achieve short- and long-term financial and lifestyle goals... A
vital part of the financial planner’s role is helping consumers appropriately
manage debt and implement a savings plan... This is specifically not about making
a recommendation about credit products; [but] they very clearly need to
understand the debt and asset position of their client to be able to make
suggestions about financial management.[18]
Margin Calls
4.34
Another important aspect of the bill is a provision which regulates the
notification of margin calls to clients, especially where the loan has been
arranged through a financial planner.
There have been situations where it has been unclear whether
it was the lender or the planner who was responsible for notifying clients when
a margin call occurred. Failure to notify a client in time can result in losses
for the client. The amendments require that lenders must notify clients when a
margin call is made, unless clients explicitly agree to notifications being
provided through their planner.[19]
4.35
The Financial Planners Association of Australia welcomed the additional
safeguards contained in the legislation to ensure that arrangements to receive
notifications through agents are only effected on client request.
However, the sole notification of agents may be inappropriate
in some circumstances. While the use of agents may be helpful in steady market
conditions, it may be less appropriate at times of unusual market volatility,
when agents may face a high volume of margin notifications, thus increasing the
potential for delays in passing notifications on to clients. Where a quick
response is required, it would be more appropriate for both client and agent to
be informed.[20]
4.36
The Australian Financial Markets Association (AFMA), in indicating their
support for a national regime to regulate margin lending, emphasised that:
This necessarily includes procedures that support effective
disclosure, proper margin call notification procedures and good lending
practices.[21]
Committee view
4.37
The Committee supports the Government's decision to include margin loans
as a financial product in Chapter 7 of the Corporations Act 2001.
4.38
The Committee also notes that the Parliamentary Joint Committee on
Corporations and Financial Services is currently conducting an inquiry into
financial products and services, including the conduct of certain organisations
with regard to margin lending.[22]
4.39
The Committee feels that, as most businesses who offer margin lending
products already hold Australian Financial Services Licenses, the proposed
licensing regime will impose less of a burden on the industry than would be
imposed if an equally strong regime were established separately.
Trustee Corporations
4.40
Trustee corporations provide, among other things, 'traditional services'
such as the administration of personal trust and deceased estates, including
acting as a trustee of a trust, applying for probate of a will or acting as an
executor of a deceased estate. Trustee companies that wish to operate in more
than one jurisdiction (i.e. in different states) must comply with differing and
often inconsistent authorisation and reporting requirements. This creates
considerable burdens for many trustee corporations.
4.41
As explained in the Explanatory Memorandum:
The private trustee company industry is relatively small with
ten licensed private trustee companies. The majority of these trustee companies
are licensed and operate in multiple jurisdictions.
There are also eight public trust offices. These trustee
companies have been regulated at an entity level under State and Territory
regulatory regimes. As the majority of trustee companies operate in multiple
jurisdictions, the need to obtain a licence in each individual State and
Territory, combined with the lack of consistency in licensing requirements,
creates barriers to entry and restricts competition in the marketplace.
In order to offer funds management services, all of the
private trustee companies hold Australian financial services licences (AFSLs).
As a result, they are familiar with regulation by the Australian Securities and
Investments Commission (ASIC) and the requirements of an AFSL.[23]
4.42
The bill introduces a requirement that both public and private trustee
companies hold AFSLs.
4.43
The legislation also streamlines the dispute resolution process
available to beneficiaries to enhance the protection available for trust
assets. Currently, in the absence of internal dispute resolution services
voluntarily provided by the trustee company, the Supreme Court is the only
avenue of recourse for beneficiaries with concerns about the management of the
trust or estate.
4.44
The Commonwealth is relying on its legislative power under section
51(xx) of the Constitution (which empowers the Commonwealth to make laws with
respect to foreign corporations, and trading in or financial corporations
formed within the limits of the Commonwealth) to make this law, rather than
seeking a referral of power from the States.
Evidence in relation to Trustee
Corporations
4.45
The Trustee Corporations Association of Australia (TCA), which
represents all eight Public Trustees and the majority of the 10 private
statutory trustee corporations, has welcomed the announcement that the
Commonwealth would take over responsibility for the regulation of trustee
companies. However, they highlight their concern about how the approach will
work in practice with the Commonwealth:
assum[ing] exclusive responsibility for ‘entity level’ regulation of traditional trustee company services, but existing State and
Territory legislation, and the rules of common law and equity... continu[ing] to
govern the functions and powers of trustee companies.[24]
4.46
The TCA are concerned that the bill does not introduce unnecessary
duplication or hamper the objective of enabling trustee companies to carry out
their activities as efficiently as possible.
Promissory Notes and Debentures
4.47
The bill amends the Corporations Act to create a consistent
approach to the regulation of promissory notes to address issues that arose out
of the collapse of the Westpoint group. Following Westpoint's collapse, the
Government undertook a review of the regulatory regime for debentures, with the
aim of protecting retail investors.
4.48
Westpoint group, a property developer, collapsed in January 2006
resulting in what ASIC estimates will be a total loss of $329 million for
investors in the group's financial products.[25]
4.49
One of the main issues arising from the Westpoint case was the
inconsistent regulation of promissory notes and debentures. Treasury explain:
Promissory notes, a form of debenture and debt instrument,
are used by the issuer to raise funds from retail investors. In return, retail
investors receive interest on their investment. However, the current regulation
of a promissory note differs depending on its value: promissory notes valued at
less than $50,000 are generally regulated as debentures; at $50,000 or over,
generally as financial products. This difference derives from distinctions
between retail and wholesale investors incorporated in early 1980s legislation
which is now considered to be anachronistic.[26]
4.50
Westpoint issued promissory notes with a face value of at least $50,000
in an attempt to obfuscate having the debt treated as promissory notes by ASIC
and therefore having ASIC's jurisdiction over their compliance monitoring
challenged. Because of the uncertainty, ASIC attempted to come to an agreement
with Westpoint about the treatment of this debt. In a Senate Estimates hearing
on 25 May 2006, ASIC gave the following evidence:
There was an express exclusion [in the Corporations Act] for
promissory notes over $50,000 from the definition of ‘debentures’; that was the
problem. We looked at what could be done given that that is what the situation
appeared to be, that these were not covered by the legislation that we are
tasked to regulate. We developed an argument that we thought had some merit and
we thought we needed to raise directly with Westpoint to persuade them that
what they were doing, which purported to rely upon the exclusion, did not in
fact do so...
It would be fair to say there was a lot of toing-and-froing
between ASIC and Westpoint and in particular their lawyers, Freehills—they
might say ‘toing-and-froing’; we might say ‘cat and mousing’—over this issue.
We eventually realised by the end of 2003 that we were being stalled, we were
being given the run around, and we delivered an ultimatum to Westpoint to
either comply with the argument that we had put forward about the Corporations
Act or we would take court action. We ended up taking court action to force
Westpoint to comply with the Corporations Act, based on a very difficult
technical argument that in part relied upon an interpretation of the Bills of
Exchange Act rather than the Corporations Act. Nonetheless, we had to fight for
our jurisdiction and that is what we did.[27]
4.51
The court finally determined that the issue took the form of an interest
in a managed investment scheme (rather than a debenture that had to comply with
the relevant debenture provision in the Corporations Act).
The Proposed Reforms
4.52
The amendments proposed in this legislation seeks to improve regulatory
certainty and clarify the law by amending the definition of debentures so that
promissory notes valued at above $50,000 fall into the definition and therefore
are subject to the same regulatory regime.
4.53
The amendments also provide for the establishment of a register of
debenture trustees who will provide a level of investor protection for
debenture holders. Only certain entities are permitted to undertake this role,
as set out in Chapter 2L of the Corporations Act. Trustees' duties include
those set out in the Corporations Act, as well as those in ASIC's guidelines on
debentures. The guidelines emphasise the need for trustees to monitor the
financial position and performance of the debenture issuer.
4.54
The amendments also aim to enhance transparency by providing for public
access to the list of trustees, who are required under law to represent the
interests of investors and undertake important responsibilities on their
behalf.
Evidence in relation to Debentures
and Promissory Notes
4.55
Treasury have indicated that, during the Government's consultation
process with regards to this bill, there was broad support for this amendment
as it would clarify the operation of the legislation and provide consistency.[28]
In June 2009 the Government released for consultation the
Green Paper... Twenty submissions were received in relation to debentures. While
four possible reforms were canvassed, after discussions with ASIC regarding its
forthcoming review of debentures, it was decided to proceed initially with only
the promissory notes amendment...
Conclusion
4.56
The Committee welcomes the Financial Services Modernisation reforms
contained in this bill.
Recommendation 12
The Committee recommends that the Corporations Legislation
Amendment (Financial Services Modernisation) Bill 2009 be passed.
Senator Annette Hurley
Chair
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